Has the Fed Missed the Zero Rate Exit Ramp?

Economics

Tantalus was eternally doomed to stand
in a pool of cool water beneath a fruit
tree. Whenever he reached for the fruit,
the wind would blow the branches out of
his reach; if he kneeled to drink, the water
would drain away.

After years of extreme policy, the Fed’s
twin goals of faster growth and 2%
inflation remain tantalizingly out of reach.
But are the Governors ready to look past
the commodity bust, a strengthening
dollar, and a near meltdown in Chinese
stocks, and “tighten” policy for the first
time in nine years?

The Fed has talked the talk of “exit
strategies” for years. The bank once upon
a time asserted that the “trigger” would
be 6.5% unemployment. That “trigger”
became a “threshold” which became a
“dashboard” and then merely an
assurance that the Fed would be “data
dependent.” And the Fed now agonizes
over whether a rise in rates of ¼ of 1% in
September might need to be taken off the
table. Is the recovery so tenuous that
even a “technical” move off the zero
bound might place it in jeopardy?

If so, then why continue a policy regime
whose “fruit” reeks with the rotten odor
of deflation? Rather than acknowledge
that the policy might actually be wrong,
apologists for the Fed insist that punk
growth and quasi-deflation require – you guessed it – still lower for longer. Yet, if
prosperity were truly a function of adding
leverage and cheapening credit, shouldn’t
the recovery be brimming with animal
spirits by now? Ah, but we are told that
this time is different. The financial system
suffered a “coronary” and home prices
tanked nationally for the first time since
the 1930s. Or, we have “secular
stagnation” – everyone just got suddenly
old in 2008 and Silicon Valley ran out
of innovative ideas. Yet, have not home
prices rebounded and stocks attained
record highs? And do we not see vast
valuations being applied to tech
businesses on the presumption that their
frame breaking business models will yield
a cornucopia of productivity gains and
wealth creation? Face it: if zero rates
were going to do their magic, seven years
is a more than adequate window of time
to be shocked and awed by its power.

Well, as the old saw goes, you’re either
part of the solution or you’re part of the
problem. Could it be that low rates
not only can’t cure but are actually the
cause of our serial misses on GDP
and inflation? Well this sounds like
heresy: after all, aren’t lower rates
“better” than higher rates?

They are not! Interest rates are prices
and like all prices they have a job to do:
to ensure that scarce resources go to
where they do the most economic good.
When market clearing prices are
permitted to emerge from the soup
of borrower/lender preferences, the
expected result should be an information
rich allocation of capital. When the
market’s mechanism is overridden,
because the central banker “knows
better”, locally known information
pertaining to producer efficiency and
buyer urgency is lost. Suboptimal credit
pricing begets suboptimal resource use
which retards growth. Zero rates, far from
being stimulative, poison the tree.
Consider the far reaching and unintended
consequences of ZIRP:

Legacy borrowers receive financial
relief enabling inefficient enterprises to
outlive their usefulness. New trees
can’t grow where there is dead wood,
as Japan learned with its zombie
companies.

Cheap loanable funds that fail to reflect
the true economic cost of using a
resource misdirect economic activity.
Every real resource has a range of uses,
from the sublime to the ridiculous.
Sublime users are supposed to go to
market and outbid the ridiculous users
so that resources go to those who
place the highest value on them.

Abnormally low rates and risk premia
have fostered a “reach for yield” which
has distorted judgment of relative risk
and reward. An excess of capital flows
into energy, commodities, high yield,
and emerging markets are emblematic
of such resource misallocations.

“Trashing cash” has spurred real-estate
prices. Those with expensive homes
have seen their “collateral package”
enlarged enabling them to borrow
more and on better terms when facing
their local banker. No surprise, then,
that higher home prices encourage
more investment in swimming pools
and, tautologically, less in say
expanding payrolls at small and
medium enterprises.

This list could go on. The Fed, we are
sure, is full of good intentions and
technical competence. That said, financial
markets excel at resource allocation in a
way that central direction never can. Price
information is invisible until a market
mechanism “reveals” it. And information
is the key to getting the right resources to
the right places at the right times. Policies
of financial accommodation outlived their
usefulness years ago. Resources have
been misallocated, capital misdirected,
and so cleaning up the mess created by
ZIRP will be costly.

Regretfully, we can see only two options
ahead for the Fed, and neither one of
them is good. It can throw away the
playbook and accept that a real rate
normalization will happen eventually, no
matter what. In that event, the Fed can
use September as the starting point for
taking us back home to a world of normal
market clearing short rates. Lifting rates
over time to even 2% would mean that
real short rates would be just barely
positive. Of course, the likely result of
tightening to 2% would be recession.

Then why do it? Because the second
option is potentially worse. Allowing
rates to remain artificially low keeps asset
prices artificially high. Effectively, the Fed
keeps “riding the brakes” and calling it
progress. The conundrum is that
expanding leverage in a slow growth
economy eventually fails – often
dramatically.

Sooner or later, the inevitable deleveraging
will come, catalyzing a bear
market for risk assets. We counsel
investors to remain mindful of the asset
price cycle and skeptical of the claim that
risk-centric strategies will be – or can be –
forever sponsored by the Fed.